百事 (PEP) 2006 Q2 法說會逐字稿

Welcome to PepsiCo's second quarter 2006 earnings conference call. [OPERATOR INSTRUCTIONS] Today's call is being recorded and will be archived for 14 days.

It is now my pleasure to introduce Mr. Jamie Caulfield, Vice President of Investor Relations.

Sir, you may begin.

Thank you, operator, and good morning, everyone.

Thanks to all of you for joining us this morning.

Today's webcast includes a slide presentation that can be accessed at our PepsiCo.com website.

Before we begin, please take note of our cautionary statement.

This conference call includes forward-looking statements based on our current expectations and projections about future events.

Our actual results could differ materially from those anticipated in such forward-looking statements, but we undertake no obligation to update any such statements.

Please see our filings with the Securities & Exchange Commission including our annual report on Form 10-K for a discussion of specific risks that may affect our performance.

You should refer to the investors section of PepsiCo's website at www.pepsico.com under the heading PepsiCo Financial Press Releases to find disclosure of any non-GAAP financial measures that may be used by management when discussing PepsiCo's financial results with investors and analysts and a reconciliation of those non-GAAP measures to the related GAAP reported measures.

This morning's prepared remarks will be made by Steve Reinemund, our Chairman and CEO; and Indra Nooyi, our President and CFO;

Steve and Indra are joined this morning by Mike White, Chairman and CEO of PepsiCo International; and by Dawn Hudson, PepsiCo and North America's President and CEO.

Following the prepared remarks, Steve, Indra, Mike, and Dawn will be glad to take your questions.

Now, I am pleased to turn it over to Steve Reinemund.

Thank you, Jamie, and good morning, everyone.

Thanks for joining us again this morning for our call.

Because we have Dawn and Mike with us this morning our prepared remarks will be a little shorter than usual in order to allow for more time for your questions.

I trust that all of you saw the release this morning.

We had a strong quarter and our results actually accelerated a bit from the first quarter which was also a very good quarter.

Again this quarter the results were characterized by terrific balance.

All of our divisions grew the top and bottom line, and we had growth in both snacks and beverages across each of our major geographies.

Global snacks grew 8%, global carbonated soft drinks grew 5%, and global noncarbonated beverages grew 23%.

We're especially pleased with the division's operating results in light of the input cost pressures that we're all dealing with.

We continue to feel inflationary pressures principally from energy and energy related costs and in the case of Pepsi Cola -- or Pepsi Beverages North America from increased orange costs.

Our approach in managing through this environment requires the businesses to balance the volume price equation.

As most of you know our categories are highly price elastic.

We don't take pricing decisions lightly.

I have mentioned in the past that we don't want to overreact to cost increases and take short-term pricing actions that jeopardize our market positions or the long-term health of our businesses.

You will see some short-term gross margin and operating margin contraction as a result of this input cost inflation.

Based on our first half results, I am comfortable that our operating divisions are making the right decisions in this very important volume priced trade-off.

Within the divisions, international continues to perform very well.

What's noteworthy this quarter is that while the emerging markets continue to grow very rapidly, we also had solid performance in each of our big developed markets with Sabritas, Gamesa, and Walkers each putting up very good numbers.

In North America the divisions had strong performance.

Revenue in North America was up 10% in the quarter and we had good beverage growth driven by our noncarbonated beverage portfolio, especially Gatorade and Lipton and from Frito-Lay North America which had healthy growth in both core salty and in the Quaker Snack products.

As we mentioned in the release our emphasis on health and wellness is paying off as evidenced by the performance of our Smart Spot eligible products which had almost 20% revenue growth.

We're optimistic about the future, all the businesses are performing well, and we have room in the P&L to continue to invest in the long-term health of our business.

Now let me turn the program over to Indra, to comment a bit more detail on each one of the divisions and to take you through some corporate items, and then we'll open up for questions.

Indra.

Thanks, Steve.

Let me start with Frito-Lay North America.

Frito-Lay had very strong performance in the quarter, volume was up 4%.

We had good price mix with revenue up 8%, and profit was up 7%.

The numbers include some top line benefit from the Stacy's acquisition, but no profit benefit as we're scaling up the organization for growth.

Among our largest trademarks, Lay's, Tostitos, and Cheetos all had solid growth in the quarter.

While Doritos was down slightly, we saw sequential improvement in the trademark's performance.

We just launched the new Snack Strong ad campaign.

We've gone back and tweaked the packaging on the nacho cheese product, and we have a couple of new national product launches, Fiery Habanero has just been rolled out nationally, and later this we'll we'll be introducing a new blazing buffalo and ranch flavor.

At this point we're feeling a little bit more optimistic about Doritos.

We continue to see very good performance in our Smart Spot eligible products.

These products in total had 20% volume growth in the quarter driven by products like Sun Chips, Baked Lay's and Baked Crunchy Cheetos.

Sun Chips in particular are doing very well.

We added a manufacturing line for Sun Chips in April, and we've already maxed out on the added capacity.

Our other macro snacks also had another strong quarter.

Our macro snacks volume in total was up 10% and revenues were up 16% with very strong growth across the Quaker Snacks portfolio.

Rice Snacks were up over 40%, and Quaker Chewy Granola Bars grew more than 20%.

The Quaker Snacks line is benefiting from a combination of being on trend with health conscious consumers, the brand relaunch that we executed in 2005, and new products like 90-calorie Quaker bars we introduced in the second quarter, and the reduced sugar granola bar that we introduced late last year.

Portion control packaging is driving growth also.

Our variety packs including our new 100 calorie packs are doing very well and were an important contributor to growth in the quarter.

Finally, since our last call, we announced that Frito-Lay will be cooking Lay's and Ruffles using heart healthy sunflower oil which will reduce by more than half the amount of saturated fat found in other cooking oil.

We're rolling this out nationally starting in the northeast where the concept was tested.

Consumer response has been very positive, so we think this move will be a big win as it relates to our health and wellness agenda, and it will be a big win with our consumers The national rollout should be completed by November of this year.

Turning now to PepsiCo Beverages North America, the business had a very strong quarter with total volume growth of 8% and very strong growth across our company's portfolio which was up 23%.

Within carbonated soft drinks, both trademark Mountain Dew and Sierra Mist posted positive growth for the quarter although we did experience a low single digit decline in trademark Pepsi.

At the end of this month we launch Pepsi Jazz which is our first major CSD introduction this year, and we expect the launch to reinvigorate trademark Pepsi performance.

Net revenue was up 13% which reflected the positive revenue mix benefit of the noncarbonated beverage group.

As you saw in the release, Pepsi Beverage North America's profit performance reflected increased costs in oranges at Tropicana and higher energy costs.

The operating profit also reflected the benefit of a $29 million insurance settlement which was largely offset by lapping the trade spending accrual settlement we recognized last year.

Gatorade was up 29% in the quarter.

The business overall is doing extremely well, and the result of the rain sublime continued to track above our expectations.

Our waters trademarks had very strong growth in the quarter, Aquafina was up over 20%, and Propel Fitness Water was up over 30%.

Aquafina continues to benefit from the Flavor Splash line including the new grape flavor introduced in February, and Propel is benefiting from the introduction of our new Propel With Caution line which was introduced in January.

Our Lipton Ready-to-Drink tea business grew over 40% in the quarter, and we continue to see very positive results across the entire line.

The Starbucks products continue to perform very well also.

The core Frappuccino product continues to post very strong growth, and our new products like strawberries and cream Frappuccino, Starbucks Double Shot light and the new Starbucks iced coffee product are exceeding our expectations.

We are in the midst of the Pepsi Cool Tunes and Motorola phones promotion which has had very good consumer response and we're excited about our Power of One tie-in with the Superman Returns property which has been a blockbuster at the box office.

In October we launched Dole Sparkling, which is a low sugar sparkling juice, and then follow-up in November with Sierra Mist First limited time only offering for the holidays.

We were also pleased to announce earlier this morning our alliance with Ocean Spray to market, bottle, and distribute single serve cranberry juice products in the U.S. and Canada under the Ocean Spray trademark.

The Ocean Spray name is synonymous with cranberries, and we're thrilled to have the opportunity to expand our healthy beverage portfolio with such a terrific brand and product.

So overall the North American beverage business is doing very well with strong results in the non-carb portfolio and exciting news and promotions for the balance of the year.

Moving now to PepsiCo International.

PI had yet another terrific quarter with snacks volume up 11% and beverage volume up 10%.

As Steve mentioned, growth was very broad based.

In beverages carbonated soft drinks grew 9% with each of our four major trademarks showing solid growth.

Noncarbonated beverages were up 26% with Gatorade, juices, water, and Lipton Ready-to-Drink tea each growing double digits.

As you saw in the press release this morning, each of the three international regions had strong beverage volume growth.

In snacks we had double-digit growth in both the Asia Pacific region, which was up 14%, and the Europe Middle East, Africa region which was up 17%.

Importantly, growth in this region reflects an acceleration in the growth of our U.K. snacks business which was up 4% in the quarter.

I think the solid results in the U.K. are an indication that the Walkers brand relaunch and the focus on health and wellness are both paying off.

In the Latin America region Gamesa returned to positive volume growth and continues to benefit from a favorable product mix shift.

Finally, our Quaker Foods North America business had another solid quarter with good top line growth and positive profit performance even as it lapped our 24% profit growth from the second quarter of 2005.

We continued to feel pressure on commodity costs with the largest impacts from energy which affects all of our divisions and from the hurricane related increase in orange costs which is a Tropicana specific issue.

The balance of our key input for the fairly benign net impact across all our businesses although cooking oil was up at Frito-Lay.

Even though our gross profit dollars increased more than 9% this quarter, our gross profit margin for the quarter was down versus last year.

This was largely driven by gross margin declines at PBNA, Pepsi Beverages North America and to a lesser extent at Quaker Foods North America.

Let me comment briefly on the Pepsi Beverages North America gross margin since that's the predominant driver of the overall decline.

What you're seeing at Pepsi Beverages North America is a combination of the increased costs in oranges and energy that I just mentioned, as well as the impact of our mix shifting to noncarbonated full goods which have a higher revenue per case but a lower gross margin percentage.

Overall we are very pleased with how the divisions have managed through inflation this year.

We've had no major surprises versus what we had planned.

As we look out for the balance of the year, the bulk of our energy costs are covered through the end of the year so we have good visibility into our energy cost outlook, and although orange costs have gotten a bit lower since we last spoke, our balance of year outlook has taken higher orange costs into account. [Foregs] had a very slight positive impact in the quarter with the upside driven by the Canadian dollar.

The Mexican peso, the pound and the euro our other key foreign currencies, each declined versus the dollar in Q2.

For the full year our expectation is for foregs to have a very modest favorable impact on both the international line of business and on PepsiCo in total.

Let me now comment on the P&L below the division line.

Corporate unallocated costs increased approximately $1 million in the quarter.

Corporate departmental costs were essentially flat and costs associated with our business process transformation initiative increased by approximately $10 million which was essentially offset by declines in other areas within corporate unallocated costs.

Both our equity income reflects a year on year increase of $20 million and a gain on the sale of shares in the Pepsi Bottling Group.

In the first quarter of 2005 we initiated a multi-year program to return our ownership in PBG to approximately the level at the time of the IPO, it is about 40% on an economic basis.

Our proportional ownership when we initiated the program last year was 46.4%, and our ownership at the end of the second quarter was 43.5%.

The program is on track to return our ownership to the targeted level.

Net interest expense increased by $8 million which reflects the impact of lower cash balances, higher average rates on our borrowings, and higher rates under our investment balances.

The tax rate for the quarter was 28.7%, a reduction of 60 basis points from the second quarter of 2005.

The second quarter rate is above the 28% rate we've provided in our previous guidance, and we now anticipate our 2006 full year ongoing effective tax rate to be approximately 28.4%.

For the quarter average diluted shares declined by approximately 1.3% or 23 million shares as compared to the second quarter of last year.

Turning now to cash flow, year-to-date we've generated $1.8 billion in cash from operating activities which is lower than our first half performance of 2005.

The cash flow performance reflects an increase in cash tax payments of $683 million which includes the $420 million tax payment we made in the first quarter related to last year's international cash repatriation.

The operating cash performance also reflects working capital investments in inventory and receivables which are driven by the seasonality of our business and by underlying business growth.

Overall our working capital key performance indicators remain within our targeted levels.

Capital spending is $708 million year-to-date, an increase from last year but in line with our projected full year increase in capital spending.

Option proceeds for the first half were $697 million on exercises of 19 million options.

We returned approximately $2.3 billion to shareholders through dividends and share repurchases.

Finally, turning to guidance.

As you saw in the release, based on the strength of the first half we've revised our full year earnings guidance to at least 2.95 per share.

This full year outlook takes into account the positive momentum of the business, but also factors in our expectation for a continued challenging input cost environment.

And as most of you know, our third quarter is particularly challenging from an overlap standpoint.

In Q3 of 2005 revenues were up 13%, division operating profit grew 14%, and EPS grew 18%.

This should be factored into your models as well.

Our cash flow outlook remains unchanged from what we shared with you in April.

We expect cash from operating activities to exceed $6.2 billion and capital spending of $2.2 billion.

Our original outlook assumed pension funding for 2006 of $250 million.

Based on our current funding and expectations for the discount rate, it is likely that our pension funding could be lower than the original assumption, but that lower pension funding may be offset by higher cash taxes.

So net we're going to keep our cash flow guidance exactly where it was in the beginning of the year.

We also anticipate share repurchases of approximately $3 billion for the full year, again consistent with what we said in April.

To sum it up, we feel good about the business, and we're pleased with the first half results.

All our businesses are on track, and although we have to deal with the commodity cost inflation, we're confident in our full year outlook.

Let me turn it back to Steve.

Thanks, Indra, and operator at this point we're prepared to take questions.

[OPERATOR INSTRUCTIONS] Your first question is from Bill Pecoriello of Morgan Stanley.

Good morning, everybody.

First question, just on the gross margin would you expect a similar magnitude decline in the second half given the mix impact to the orange and energy impact that you referred to?

Indra.

Bill, the impact in the first half was perhaps higher than we expect the impact in the second half.

However, the outlook for oranges is also a function of what the crop looks like in the second half and the outlook for hurricanes.

So at this point if nothing changes in the environment, I expect the gross margin improvement -- gross margin decline to be less in the second half, but at this point a lot is dependent on what the orange crop comes in at, and also what the PET availability looks like in Q3 and Q4.

Just one other question.

On the SG&A, you're getting some leverage there.

I wanted to understand the marketing spend increase.

Last year you had increased the Frito-Lay pole spending 50% on the core brands.

Are you increasing further this year and what's the overall market spending for the Company going up as you're getting leverage into G&A?

Just trying to separate out the components there.

Just that our A&M did grow, but it didn't grow in line with the 12% sales increase.

That was one of the major areas along with some productivity improvements that we had in the SG&A line, Bill, that gave us the leverage and the operating margins.

Is the Frito pole still up year-over-year as you're lapping that big increase from last year?

Yes.

Thank you.

Thank you.

Your next question is from Bonnie Herzog of Citigroup.

Good morning.

Good morning.

I would be curious to hear from, actually Mike, if he has an internal time frame as to when his international division can possibly achieve operating margins that are similar to what is generated from Frito-Lay and I guess Pepsi Beverages in North America?

And if you could kind of walk through that for us and also possibly identify any obstacles that are preventing the business from ever achieving the same level of margins.

I think that would be helpful for us.

Good morning, Bonnie.

It is Mike.

Hi.

In the past I have said that I certainly expected us to continue to see continuous margin improvement, certainly to mid-teens.

I guess we're kind of there, so we need to revise our target and make it a little higher which as you can imagine we're doing.

I think we have businesses within International which have very similar margins if not better margins in some cases than Frito-Lay North America as well as PBNA, but we also have emerging market businesses that have lower margins because the scale isn't quite where it might be in those businesses.

And the thing in a complex International portfolio, you have an overhead structure to manage the number of countries that we're in that our Frito-Lay North America doesn't have.

I don't think that's necessarily the right target, although I would certainly love to see us get there.

I am really pleased with the progress on our margins this year.

I expect we'll continue to see some improvement in the second half of the year, and as I have said before, I certainly expect to see continued margin improvement next year, over the next several years.

Now, as our margins get higher and higher and our business gets larger and larger, I think it will be easier for us to deliver that.

Our big three businesses have similar margins to Frito-Lay, so we know how to do it, and it is a step by step process in building scale on the business.

Actually that sort of begs for a second question if I may which is--how you are sharing best practices?

As I hear you speak and we've seen the success of PepsiCo over the last several years, the consistency, I feel like your company has such a unique opportunity given your size to really act even more as a global company, and I know Dawn is on the line as well, in how you two interact and how you're sharing ideas?

Are you starting to see that happen more, and can we expect more in the future?

First off I will start and then Dawn is sitting next to me and I will be happy to have her chime in as well.

First of all, there is no question I spend a large part of my time thinking about how we ensure that we're getting the best practices in our company shared in what has become a very, very large and complex International portfolio.

For instance, we had 400 people in for a sales and marketing best practice sharing expo just last month.

It is something that I started when I was at Frito-Lay Europe, Africa, Middle East in 2000 and have continued, and it has kind of become a regular event each year as we put our strategic and operating plans together for the following year.

We also have a number of councils that we have set up such as a sales council, we have a marketing council, we have an emerging markets council which also helps us ensure that we're sharing the best practices.

We have an operations council that ensures that we're sharing productivity ideas around the system.

Obviously as I travel, I try to do the best I can to ensure that we're sharing.

In addition, we have an R&D -- we both do all of our training of R&D together, and we also leverage each other from an R&D standpoint.

We have a number of centers of excellence in R&D in both snacks and in beverages where we have a shared service with North America, and we also meet on a regular basis with our R&D people between the businesses.

I think you're seeing already we're taking ideas from the U.S. into International like Baked Lay's, is what's going to be called Baked Walkers we're going to be launching in September, and similarly on the beverage side we have got Lipton Iced Tea that we're looking to launch in Mexico.

But I continue to believe that the magic of International has been to get the right balance between global and local, and we've been very successful in doing that, and I expect that we'll continue to do that in the years to come.

Dawn, do you want to add a comment from your perspective?

I will only add three brief comments, Bonnie.

One is that just within the North American beverage business, the complexity and the change in that business over the last five years has required that PBNA even within the U.S. take more of a leadership role in sharing best practices.

And on the International side we are very much aided by what Mike referred to, which is we have a global R&D organization.

The team that works on carbonated soft drink innovation works on it around the globe.

Sweetener technology, flavor development, it is automatically shared with a shared packaging development group, and our marketing group from an International global perspective and domestic sit right next to each other in the same buildings and have operating teams.

So we share and we're actually -- do some launches together globally, so I think it is a very important opportunity in learning and certainly the world is a melting pot and great ideas come from everywhere.

Okay.

Thank you both.

Great to hear.

I would just like to add one thing, Bonnie.

Mike talked a little bit about this 400 people that came into see the ideas from around the world.

Mike has done a great job in the last few years in really developing this venue for sharing.

It brings out the best of the PepsiCo what I call DNA, and that is the balance between division ownership and people all around the world owning their businesses with sharing ideas, and we now have enough scale in the International business that one of Mike's key executives, Massimo D'Amore who has been in a line operating role and up until his recent assignment to head up the staff function, he really is the individual who helps on a regular day-to-day basis move the marketing ideas around the world.

He understands the line pressures having been a line operator, and he has a viewpoint like Mike does across the world, and so his staff is every day working to balance that local and International sharing across the business, and I am very pleased and proud of how they're doing that now because we have the scale to afford it, and we have the culture of working together that allows that to happen.

All right.

Thank you so much.

Thank you.

Your next question is from Caroline Levy of UBS.

Good morning and congratulations on a great quarter.

The top line was pretty astounding and one of the things I am thinking about is you have a major management change at fraternal North America and if you could just give us some assurances about how the transition, and I don't know if it's already happened or how that is going and whether you see any risks or maybe just tell us a little bit about how things might change or not change at all.

Caroline, it has happened.

It happened a week ago Monday.

I can tell you, I was there for the announcement at headquarters, and it was quite an electrifying morning.

I have been in a lot of meetings at Frito-Lay over the years and I can honestly say I have never seen a more enthusiastic group.

Al Carey got two standing ovations from the people there.

He is no stranger.

He started his career there in the early 80's, rose through the organization to be Chief Operating Officer before he came up to PepsiCo to start the Power of One effort, was very successful in developing Power of One to where it is today and in that process he was very involved in all of the operating divisions.

He probably more than any other executive in the Company had views into all of the U.S. businesses and obviously given the size of Frito, he had a particularly relevant and consistent involvement in the Frito business.

I would tell you we're not going to miss a lick at Frito-Lay.

The strategy that was set before was excellent, and that's going to continue.

We're going to continue to emphasize our strong brands and to move the business to more and more of a pole business, and none of that is going to change.

The strategy is sound.

Al has been involved in it.

In fact, I spoke to him last -- late last night on some issues and he says already he feels quite at home and up to speed with all of the day-to-day issues at Frito-Lay.

I am very, very comfortable that Frito is in good shape.

I think the performance in the second quarter speaks for the strength of the business, and I am very optimistic about the future of Frito.

Excellent.

And then I was just wondering if Dawn could comment on those Ocean Spray arrangements?

Something had failed somewhat in the past and how this is different and how meaningful this might be relative to say a Starbucks joint venture, other joint ventures you have.

Certainly, Caroline.

First of all, it is a new relationship, it's an alliance, but in many ways it bears on the strength of our JV's in that Ocean Spray brings the knowledge of cranberries and cranberries is a growing health and wellness ingredient and we bring the power actually of the DSD system and our knowledge of broad based LRB beverages.

So what's different in the past is it was a distribution agreement.

It was a distribution agreement only, and now it is a broad alliance and partnership where we'll be bringing out a host of new items carrying the Ocean Spray trademark that we will jointly develop together.

It begins with the single serve businesses and then continues with innovation and I really think it provides another platform and brand for PBNA beverages which we can leverage in the growing health and wellness space.

I might just add, Caroline, that I think under Dawn's leadership at Pepsi, we've got a good history of having strong alliances and having win-win relationships with our partners.

The Lipton partnership, Starbucks partnership, very, very well managed, mutually beneficial relationships, and we have the same optimistic view towards the Ocean Spray arrangement.

Thanks so much.

Thank you.

Your next question is from Lauren Torres of HSBC.

Good morning.

Dawn, I was hoping you could talk a little bit more about brand performance on the beverage side, seeing CSD's and trademark Pepsi week, has there been any improvement on that side or are we just becoming more and more focused on non-carbs?

Maybe with some new products coming out that could help, but I was just wondering about your strategy for trademark Pepsi.

Lauren, I am going to ask Dawn to comment on this, but I would like to make a few broad based comments to start it off to put it in the right perspective.

One is that we believe that the forecast for liquid refreshment beverage growth going forward is not changed from what has been historically the growth in the 2.5 to 3% range, and we see no reason to believe that won't continue.

We believe that our portfolio is very well suited to benefit from that continued growth in liquid refreshment beverages balanced across noncarbonated as well as carbonated, and I want to make sure that we make the point that our position on both carbonated and noncarbonated is very optimistic.

We think that right now there is a -- what you might call a reset going on in the carbonated side, and it is driven by several factors.

We've talked about these before.

Part of it is pricing, pricing sort of drives display performance, and display inventory.

It is also impacted by the increased availability of noncarbonated beverages in the marketplace, and obviously it has been influenced to some degree by health and wellness issues although I personally believe it is probably not as largely influenced by that as others might think.

Nonetheless, we believe that the CSD reset is going to continue for a while longer, but with increased innovation and excitement in the category which has always energized CSD, and has been a part of CSD's history for many, many years.

We think innovation added to this sort of resetting will allow the CSD business to continue to grow in the future, albeit maybe at a slower rate than we've historically seen in the last twenty years.

But to put it in perspective, we are committed to CSD's, we're committed to innovation, we're committed to brand support, and we believe in it, and frankly we're not pleased with the performance of Pepsi but within the CSD portfolio we are pleased with the performance of some of our other brands, and I am going to let Dawn elaborate a little bit more, but I just wanted to put it in perspective so we didn't get the whole conversation out of balance.

Dawn?

So picking up on Steve's comments, we do continue to believe in the carbonated soft drink business.

If you ask consumers, of all the occasions they want a beverage, still more than 50% of the time they pick a carbonated soft drink as the number one thing that fulfills their need for that occasion.

But within carbonated, they are shifting toward flavored beverages.

They're doing it for variety.

They're doing it for some perception that lighter colored beverages are healthier, and they're doing it because of the growing multi-cultural mix of the country.

That's why we're pleased we have Mountain Dew and Sierra Mist which have growth grown on a year-to-date basis.

That doesn't mean the cola category is going to go away.

The cola category continues to be a very strong part of the carbonated category and if you look at our performance year-to-date, while we're not pleased with it, it is in line with our expectations because last year we had considerable innovation in our trademark behind Pepsi lime, the relaunch of Wild Cherry Pepsi, and Pepsi One, and this year our innovation in the carbonated category and particularly in brand Pepsi is happening in the back half of the year.

We do expect those trends to improve.

Then, Steve, let me just pick up on what Dawn said and what Steve said.

Well, the overall LRB category is about 20 billion cases. 50% carbonated soft drinks, 50% noncarbonated soft drinks.

The overall category is growing over 2.5%.

I look at our portfolio, we have leadership positions in every aspect of non-carbs, and our carbonated soft drink portfolio outside of trademark Pepsi has done pretty well.

Our goal is to keep that non-carb business growing as rapidly as it has been and perhaps even try to accelerate it and on the CSD side figure out ways to reinvigorate brand Pepsi because that will get the overall CSD business back up again.

We're focusing on innovation, focusing on the pricing issues that exist in the CSD category.

I believe that pricing may be striking ahead of its time and also making sure the shelf sets are -- appropriately reflect all the innovation that's happening in CSD's because what we don't want is inventory to go down in the stores for CSD's.

We're focusing on execution of the marketplace and innovation, and our expectation is that growth will return to the CSD category.

And just to step back a second, Dawn, did you say thought that the cola category, I don't know if it is because of the lap, but you have seen somewhat weaken or has there been any signs of improvement within that category in general?

There has been a long-term trend in the carbonated category toward flavored carbonated beverages.

Colas have, if you will, as a category lost share overtime to neons, to flavored carbonated soft drinks, and within cola you have changes based upon what innovation comes in and out by the quarterly time frame, but I think what I don't want to you take away is that we're not completely committed to long-term growing the Pepsi trademark in diet and regular and bringing innovation into the marketplace across all CSD's, but particularly across colas to make sure we keep it vital and vibrant with our consumer base that still loves carbonated soft drinks and number one, colas.

Thank you.

Thank you.

Your next question is from John Faucher of J.P. Morgan.

Good morning, everyone.

Sorry to to beat a dead horse on this whole CSD issue, but a couple of questions here.

One, do you think that you're maintaining share -- let's say for the last quarter do you think you maintained share or lost share in the category.

Secondly, getting more to the financial side, Dawn, how much margin are you willing to give up as you trade Gatorade cases for CSD cases and if the margin goes down but the profit goes up, I am assuming you would view that as an okay trade-off.

What's the comfortable gap between, let's say Gatorade growth and CSD growth that gets you there to where your margin targets are that you can triangulate with your profit targets?

And then a follow-up to anyone who wants to answer in terms of talking a little bit about see store trends after that.

Thanks.

Dawn, do you want to pick that up?

Can you repeat?

I got your first question on CSD's.

The first question was looking at your performance which -- in the second quarter which seems a little below your expectations below where you want to be, do you think you maintain share in the category or you think maybe lost a little bit or even gained a little bit?

We're not pleased with our trends.

Overall, we lost very slightly on a year-to-date basis, 0.3, about 1.2 million cases on measured channels.

Now we did better in unmeasured channels.

That trend is improving, but very, very small loss on a year-to-date basis that we expect reversed in the back half of the year, but we're in line with category trends.

I am going to turn it over to Indra to comment on margin between Gatorade and CSDs and come back and talk to see stores.

To be honest, John, I think we manage the business based on what the consumer wants to buy, and we drive the innovation of each of our brands and then look at the off take of the consumer.

To be honest we don't deliberately start off by saying to make a margin how much Gatorade do we have it push versus CSDs.

That's not how we manage the business.

We look at it more from a consumer perspective.

So it sounds like the focus is going to be on driving profit as opposed to driving margin given how this is going, and if it works out that margins are down in PBNA because Gatorade is selling so much, you're cool with that?

The focus is gaining share in the overall LRB space and gaining a larger share of stomach of the consumer.

Okay.

And do it in a profit sensitive way.

But just to jump in and try to answer that question maybe from a little different light, John, we are a marketing driven, market share competitive company.

Our first focus is growing the top line and competing in the marketplace and satisfying our consumer's needs and finding what those needs are and developing products and marketing to those needs, and then we are going to figure out how to manage to the bottom line.

If you try to manage every piece of the equation perfectly, it has been my experience that you can't run a successful company, and that's -- so getting at your point, we're clearly going to chase the consumer's needs and we're going to figure out a way to profitably run our business doing that.

To your question on see stores, let me just comment from our experience which frankly is, as I think I said in previous calls somewhat counter to previous trends, given the gas price increases, we would expect to see a slowdown.

We have really frankly not seen that in our business.

In both the beverages and particularly snacks where we have completely vertically integrated internally driven company we're probably closer to that piece, and I would say we haven't seen any declines, and we're very pleased with our see store performance thus far this year.

Now, it defies logic to say that gas prices can continue up and it is not going to have an impact on us, but we haven't seen it at this point.

Outstanding.

Thanks.

Thank you.

Your next question is from Christine Farkas of Merrill Lynch.

Thank you very much.

Good morning, everyone.

A question with respect to North America really.

Given the mix at PBNA and some resulting margin pressure from the non-carbs as well as the higher energy costs perhaps which is impacting Frito-Lay North America, when could we expect to see some operating leverage in terms of margins up year-over-year?

I am not sure the nature of your question.

Do you mean when are we going to raise prices?

I would just come back to the comments I made in my opening that we try to carefully balance, understanding the long-term cost pressures versus the short-term cost pressures, and then make pricing decisions accordingly to make sure that in the highly price elastic categories which we play in that we're making the right long-term decisions.

And up to this point as Indra pointed out in her comments, we're seeing a number of our cost pressures which we don't know for sure at this point whether they're long-term or short-term, and we know some of them are quite frankly, seasonal like oranges, so we're reluctant to act precipitously in raising prices and obviously raising prices would have an impact on those margins.

Let me ask Indra if she wants to comment on the cost side of it.

Christine, on the cost side, when it comes to hurricane related events like the orange crop being wiped out a large portion of it, our energy cost increases, it is very hard to manage through those by passing all of it through to the consumer because you just don't know how much the prices are going to keep going up.

Energy, for example, is anybody's guess.

What I would strongly suggest that you do is think of ours as a portfolio of businesses.

We have our International businesses.

We have our North American businesses.

In each of our business and countries, we look at the volume price equation very, very carefully.

We have room in the portfolio because our International businesses are performing so well to manage the volume price equation in North America, and even though you see some gross margin deterioration, or some operating margin deterioration in North America the overall portfolio works and we can keep our top line growing.

If we get to a point where the portfolio has issues, we'll come back and talk about it then.

But at this point I think the overall PepsiCo portfolio is working, and we have room in those price elastic categories to manage our volume price equation very carefully in light of extraordinary inflation in energy and orange costs.

Great.

Before I move onto corporate expenses, ignoring price increases and ignoring commodity costs are difficult to forecast, would you say then that the volume leverage or the fixed cost leverage that you're getting from the NOI portfolio is moving along as planned?

Absolutely.

In fact, fixed costs, we manage our costs very, very carefully and all the fixed cost leverage that should flow through is flowing through.

Great.

On the corporate expenses we saw a pick up in the first quarter year-over-year, and then in the second quarter was really only a modest bump as you indicated of 1 million.

Was there any timing issues in the second quarter that may not be carried through to a similar extent for the second half of the year?

There was nothing extraordinary on timing.

Everything is -- I am checking with the team here.

There was nothing here that was extraordinary in Q2, Bonnie.

And in terms of -- a final question for Frito-Lay, the cost of sunflower oil in terms of your switch, is that cost lower than your current oil or higher?

Why don't we not answer that question, but roughly speaking you should assume it is a bit higher.

Okay.

Great.

Thanks a lot.

Thank you.

Your next question is from Cheryl Gedvila of Prudential Equity.

Good morning.

I had a question for you specifically about Gatorade.

If I remember correctly you had a bit of an inventory build in the first quarter that had a bit of a negative impact on the margin in that quarter, and I am wondering if that was a factor at all in the second quarter?

And also since the competitive landscape for Gatorade has changed a little bit, I was wondering if you could comment on performance in unmeasured channels versus measured channels.

I will let Indra talk about the inventory piece, but I would just say that we built up the inventory this past year because we had a shortage as you might remember.

Last summer we were capacity constrained, and we wanted to avoid that capacity constrain this summer which we believe we have, and so we're working down that inventory.

As far as the impact of the cost on the second quarter, I will let Indra answer.

Well, the other reason we are building up inventory, Steve, is because our SAP implementation piece of it is going live in Q3 of this year, and we wanted to make sure that while that was going live there was no disruption to supply, so we did prebuild inventory, and the prebuild started in the first quarter, it's continued on, and this is also the peak season for Gatorade and the business has been growing rapidly.

We have got to have inventory to service the account so that we don't have an allocation issue like we did last year along with the additional prebuild we're doing for -- in case there's any issues with our SAP launch which I hope there won't be, but you just have to plan for all contingencies.

So that's what you're seeing in the flow through in the inventory line.

As related to the competitive marketplace, obviously the isotonic category is a high growth category in the United States, and we're watching share daily if not hourly as we fight this battle, and we're pleased that we've made progress in defending our share position and actually increasing it a bit, so it is a competitive market, and in the unmeasured channels, we do quite well.

We actually relative to the measured channels which we also do well and we have even a stronger position in the end measured channels.

Okay.

Thank you.

Thank you.

Your next question is from Mark Swartzberg of Stifel Nicolaus.

Thanks, operator, good morning, everyone.

Steve, on Frito-Lay North America, I wonder if you could talk for a little bit here about your thinking on the longer term strategy there, and the reason I ask is it seems like an opportune time to do that.

Nearly two years ago you hired Irene Rosenfeld, an outsider as part of your efforts to get growth outside of the core salty snacks business.

Today obviously you're going with really quite a proven insider now, Carrie, so it begs the question of how your thinking on the strategy longer term has changed, if at all.

Well, before I answer that I might say you looked quite good on CNBC this morning, and we appreciate your comments.

Thank you.

As relates to the strategy of Frito, Irene's contribution to the strategy was a good one.

It got us focused even more on what we said earlier in the call as the pull side of our marketing effort, and we've over the last two years I think developed a very sound strategy to grow the business in the future, and the outside the core businesses have really prospered over the last two years, and we haven't talked much about it at least on this call, but they had very, very strong growth both in the first and second quarters, and we expect that to continue, and we do expect to grow the core and outside the core and really don't anticipate any strategic changes in the business.

Now, as I said before, Al was very consciously aware of and participated in the strategy at Frito-Lay in his old position and is quite supportive of that strategy and he and I have talked about it quite a bit during the last several weeks as he's moved into this position, and I can tell you that there is just as much commitment to growing the core, growing outside the core, and supporting brands and growing brands as there was under Irene's leadership.

I don't anticipate that there will be any changes in that direction and I am very optimistic about the future growth of that business.

Great.

Thank you.

Thank you.

Your next question is from Timothy Ramsey of Bear Stearns.

Hi, Carlos Laboy, Bear Stearns.

Question is for Mike White.

Mike, beyond the relaunch at Walker's, could you speak to how you think about the earnings growth at Walker's looking out to '07?

And secondly, if you could speak to the size of your Pepsi International non-carb business relative to your CSD business, and your most successful non-carb stories this summer.

Carlos, I could just barely hear you.

I think the first question I think I got which is if I can comment on Walker's and what's working beyond the relaunch of Walker's.

The second question was related to non-carbs, but I didn't quite hear what your question was.

The second question was if you could speak to the size of your Pepsi International non-carb business relative to your CSD business, and comment on some of your most successful non-carb stories this summer.

Okay.

I would be happy to.

First of all, on Walker's, as you know, as you mentioned we did relaunch our Walker's brand earlier this year with a lower saturated fat formulation with a sunflower oil which we call sun seed, and to the question was asked earlier, that's a great example of sharing because exactly that strategy is what the U.S. is planning to do at Frito-Lay I started doing in the Northeast and is going to continue to do balance of the year as they roll it out.

Our Walker's relaunch is off to a terrific start.

The -- we also relaunched Walker's sensations this year with five new flavors.

We changed the pack design and have a terrific ad with Charlotte Church that is doing very well.

We have got a couple of new flavors, beef and onion flavor of regular Walker's that we've launched.

Our Tropicana business and our Quaker business are also doing very well in the U.K., so overall we're quite pleased with the business there in that regard, so I would say, though, the core relaunch of Walker's has been key.

I would also say that we're doing a much better job executing with the trade this year.

We've got good promotional pressure with all four retailers, and that, too, has been very successful.

So as a result, actually, although our total volume was up mid-single digits, a little less than mid-single digits, Crisps was up high single digits, very high single digits, so I am really pleased with that and they're doing a good job managing their cost structure as well.

Overall, I am real pleased with the Walker's business.

Non-carbs is an integral part of our total beverage portfolio internationally.

We continue to think, though, that we're just scratching the surface on the opportunity.

We've had terrific growth in our non-carb business this year and we've had a couple of successes that I might just touch on.

We launched a product in the UK to your question called Tropicana Go which is a juice product made of 70% juice.

It is really a terrific product that we're real excited about, too early to say how big that idea is going to be.

That's off to a terrific start.

We are rolling out Gatorade in both India and in China, and we're very pleased so far with the results there.

We had a terrific Gatorade quarter in Mexico with strength up and down the board there.

We've expanded Tropicana to Thailand and Pakistan, and I am real pleased with that.

It is a very diversified, increasingly diversified non-carb portfolio, and Steve has challenged all of us I think over the next number of years we want all of our businesses better for you and good for you to be 50% of our portfolio or more, and we're not quite there yet, but we're well on the way.

Carlos, I know you asked about the best model non-carbs, and I don't know, Mike, you probably have a point of view.

I'd probably nominate at the risk of insulting one of the divisions, the Saudi business might be a model you maybe want to talk about that or if you have a model that you think is better than that.

We've got some nice -- we have some really good successes.

The Saudi we have got a nice launch of Tropicana that we started that is going very well, and we're looking to expand that in the whole Middle East region but we also have a very diversified non-carb portfolio in Russia, for example, and we started water -- a strong position in water and Tropicana in India.

In Vietnam we have got a nice non-carb portfolio with Tropicana juice drinks.

In Gatorade and Latin America has been a huge strength for us.

So we have -- I would say we have had successes in a lot of our businesses with what we still have enormous opportunities though to do is to take some of the best practices from each of those areas and cross-pollinate them.

That's what we're doing.

Our non-cash business as you saw in the release was up mid-20's, and it has been growing mid-20's and better over the last couple of years.

It has been pretty consistent I would say and I would expect to see it to continue to do that.

Thank you.

Thank you.

Your next question is from Bryan Spillane of Banc of America.

Good morning.

Good morning.

Question for Mike White.

Mike, if you look at your carbonated soft drink business that's growing at a rate that's faster than the industry, and I am just curious, first, if you could give us some idea of how much that CSD growth is contributing to the operating leverage you're getting at Pepsi International?

And then the second, as you look out I guess over the next couple of years, the sustainability of that type of growth rate, and is your expectation you're going to be able to continue to grow CSD's at this type of high single digit growth?

Good morning, Bryan, I was really pleased with the performance of our beverage business and our snacks business in Q2.

But we did have very good growth in CSD's both in developing and developed markets we had solid growth.

As I look at, I don't know that I could kind of parse the margin expansion because we also had an excellent quarter with our big three businesses and they had very high margins.

I don't know that I could comment one-way or the other on the beverage thing.

Is it fair to say that CSD's are one of your highest margin businesses?

Well, it depends.

Again, it is very hard to explain in a portfolio where I have franchise businesses that absolutely do have very high margins, but I also have in a number of the emerging markets bottling operations that have good bottling margins, but they're bottling margins, and so it is -- it is a very much -- depends on the part of the world that you're talking about unfortunately.

Okay.

But to the more important question which is kind of our overall growth rate in beverages, I certainly continue to believe that with our -- our portfolio is oriented well in emerging markets, and emerging markets have been a very strong growth performer for us the last couple of years and were in this quarter as well.

We had a very good quarter in China.

We had 27% growth I think it was in China.

We had good growth in the Middle East.

We had over 20% growth in Pakistan.

We had 16% growth in non-carbs in Russia.

So many of our emerging markets continue to perform very well, and I think that the caps are still low, and we have still got share opportunities, and we're squarely focused on those share opportunities as well.

My perspective is still absolutely.

That's our strategic goal, and I see no reason why we shouldn't continue to do that.

We had an unbelievable first quarter because of Chinese new year, but other than that our trends are very consistent, and as I said we had another good quarter in China is Q2, 27%.

Great.

Operator, I am afraid we're running a bit long on time.

We'll take one more question.

For those of you that we are going to leave stranded we will get back to you individually this afternoon.

Thank you.

Your final question is from Robert van Brugge of Sanford Bernstein.

Good afternoon.

Quick question on the working capital.

As the International business continues to grow faster than the North American businesses, do you see your working capital requirements going up over time?

Good morning, Robert.

International trade terms are not like the United States trade terms.

Some of you are DCSO, and the numbers exceed 30 days by quite a margin.

As the International business grows, yes, you will see some deterioration in the day sales outstanding.

BPOs I think we can manage quite well across the world and days inventory I think the International businesses because they have fewer plants in many countries, the DII numbers are not going to go up that much and I think those two will manage okay, but because of the day sales outstanding number, especially where you have big organized trade markets where the DCSO number is significantly higher, you will see a deterioration in working capital.

Hopefully we can look at the mix of countries and carefully manage that so it doesn't impact our cash conversion cycle too much, but yes, you have been seeing it over the last two years and I suspect you will continue to see this.

Okay.

Finally, if I may, on the capital expenditures, you're still sticking with the 2.2 billion for this year.

Do you still expect that to be moving down to a more -- a rate more in line with your historical averages after that?

The 2.2 for this year is a good number, Robert.

We are looking at our plans for 2007 and beyond.

Again, the longer term number of what we've talked about around the 5.5 is a long-term number.

At this point our businesses are growing quite well, and when you have got growth in markets and new markets, and when you have got so much growth in new technology like [Hotsell] and Gatorade, we have to put the capacity in.

Let's come back to around Q3, Q4, as to what the capital expenditure outlook is for 2007.

We are looking carefully at our growth plans before we lock and load on CapEx. 2.2 for this year is a good number.

Okay.

Great, thank you.

Thank you all for joining us.

I am sorry we ran over today.

But, as Jamie said, if those of you who didn't get your questions answered,Jamie will field those this afternoon.

Thank you for joining us and have a great Pepsi day.

Thank you.

This concludes today's PepsiCo conference call.

You may now disconnect.